Like this:

The FT has today weighed in with the argument that there is a danger of deflation in the Eurozone. And there is. We are at low and declining rates of inflation. Deflation is for a whole bunch of reasons more scary than (mild) inflation. The IMF have warned against it. Olivier Blanchard the IMF chief economist notes that for countries experiencing deflation

“On the one hand it would certainly improve their competitiveness and help exports but on the other hand it would increase the real interest rate and the real value of debt and so reduce domestic demand.”

And he concludes that the second effect will dominate.

However, it is quite possible to have the phenomena of “indeflation” – where certain sectors or regions or both experience inflation while others experience deflation.

The common measure for inflation in Europe is the HICP – harmonized index of consumer prices, published monthly by Eurostat. Below are some tables showing number of months we have seen falling prices, (measured on a moving average 12m rate of change) over the last 6 years (actually last 73 months). Look at where deflation has been happening and when. The weights of the sectors vary – but a general trend is food then housing then transport.

So for inflation as a whole we see not a huge problem…apart from Ireland where in 1 month in 3 we have seen overall consumer prices fall, and this has now reversed. Mind you Greece seems to be falling into deflation , quelle surprise

So, some tables. Feel free to interpret.

All-items HICP

Since 1/08

Since 1/13

EU (de jure)

0

0

Euro Area (de jure)

0

0

Belgium

3

0

Bulgaria

0

0

Czech Republic

0

0

Denmark

0

0

Germany

0

0

Estonia

5

0

Ireland

21

0

Greece

6

6

Spain

4

0

France

0

0

Croatia

0

0

Italy

0

0

Cyprus

0

0

Latvia

10

0

Lithuania

0

0

Luxembourg

2

0

Hungary

0

0

Malta

0

0

Netherlands

0

0

Austria

0

0

Poland

0

0

Portugal

10

0

Romania

0

0

Slovenia

0

0

Slovakia

0

0

Finland

0

0

Sweden

1

0

United Kingdom

0

0

When we dig a little deeper however this pattern masks a lot of variation. Take Food and drink for example. With the notable exception of Ireland almost no deflation in drinks prices and that some time ago. Similarly in food – no recent deflation. As food transport and household are the things people spend most money on if we do not see deflation here people will not feel that there is deflation, and where it matters to them there wont be.

Food and non-alcoholic beverages

Alcoholic beverages, tobacco and narcotics

Since 1/08

Since 1/13

Since 1/08

Since 1/13

EU (de jure)

4

0

0

0

Euro Area (de jure)

10

0

0

0

Belgium

0

0

0

0

Bulgaria

14

0

5

0

Czech Republic

14

0

0

0

Denmark

12

0

0

0

Germany

12

0

0

0

Estonia

13

0

0

0

Ireland

22

0

17

0

Greece

7

0

0

0

Spain

16

0

0

0

France

6

0

0

0

Croatia

12

0

0

0

Italy

0

0

0

0

Cyprus

3

0

1

0

Latvia

13

0

0

0

Lithuania

11

0

0

0

Luxembourg

0

0

0

0

Hungary

0

0

0

0

Malta

0

0

0

0

Netherlands

10

0

0

0

Austria

10

0

0

0

Poland

0

0

0

0

Portugal

17

0

0

0

Romania

0

0

0

0

Slovenia

6

0

0

0

Slovakia

15

0

0

0

Finland

14

0

0

0

Sweden

0

0

0

0

United Kingdom

0

0

0

0

Clothing and footwear by comparison has been hammered – and bear in mind that a lot of these come now from outside the EU. The union, it seems, should be on the plane to Prague or Warsaw or better yet coming here for their spring collections.. A pattern emerges in clothing and footware, where we have peripheral countries in persistent deflation. That bodes ill for the high street drapers in every Irish or Czech or Portugese small town. Housing remains mostly inflationary.

Clothing and footwear

Housing, water, electricity, gas and other fuels

Since 1/08

Since 1/13

Since 1/08

Since 1/13

EU (de jure)

30

0

0

0

Euro Area (de jure)

0

0

6

0

Belgium

0

0

17

6

Bulgaria

20

9

6

2

Czech Republic

73

13

0

0

Denmark

24

0

0

0

Germany

0

0

8

0

Estonia

0

0

9

0

Ireland

73

13

19

0

Greece

14

0

9

0

Spain

14

0

0

0

France

6

0

1

0

Croatia

50

13

0

0

Italy

6

0

9

0

Cyprus

59

13

15

5

Latvia

48

12

13

2

Lithuania

58

0

0

0

Luxembourg

9

0

10

0

Hungary

11

3

7

7

Malta

40

3

2

0

Netherlands

30

0

13

0

Austria

0

0

0

0

Poland

73

13

0

0

Portugal

54

13

0

0

Romania

0

0

0

0

Slovenia

41

4

7

0

Slovakia

20

0

7

0

Finland

6

6

0

0

Sweden

9

1

0

0

United Kingdom

40

2

3

0

In household furniture and white goods Ireland stands alone – persistent deep rooted deflation. Not only will the drapers be gone bust but the small electrical retailer and the local homestore will follow. The future of Irish white goods retail is, horrific as it may seem, Harvey Norman… Greece seems set to follow tipping into deflation in this area in the last year.

Furnishings, household goods etc

Miscellaneous goods and services

Since 1/08

Since 1/13

Since 1/08

Since 1/13

EU (de jure)

0

0

0

0

Euro Area (de jure)

0

0

0

0

Belgium

0

0

0

0

Bulgaria

24

1

0

0

Czech Republic

56

13

0

0

Denmark

2

2

1

1

Germany

0

0

3

3

Estonia

13

0

0

0

Ireland

73

13

9

2

Greece

20

13

13

13

Spain

0

0

0

0

France

0

0

0

0

Croatia

4

0

0

0

Italy

0

0

0

0

Cyprus

16

13

0

0

Latvia

49

13

17

0

Lithuania

22

0

0

0

Luxembourg

0

0

0

0

Hungary

5

0

0

0

Malta

0

0

0

0

Netherlands

0

0

0

0

Austria

0

0

0

0

Poland

0

0

0

0

Portugal

16

13

6

6

Romania

0

0

0

0

Slovenia

12

12

0

0

Slovakia

39

1

0

0

Finland

0

0

0

0

Sweden

31

13

0

0

United Kingdom

0

0

0

0

What can one say about communications, except what on earth is going on in Cyprus and Romania?

Transport

Communications

Since 1/08

Since 1/13

Since 1/08

Since 1/13

EU (de jure)

8

0

63

13

Euro Area (de jure)

10

0

73

13

Belgium

15

3

61

13

Bulgaria

14

4

72

13

Czech Republic

21

5

72

13

Denmark

14

5

50

13

Germany

12

2

70

13

Estonia

17

6

54

13

Ireland

19

5

17

13

Greece

13

6

48

13

Spain

12

0

61

13

France

10

0

62

13

Croatia

17

4

73

13

Italy

10

0

65

13

Cyprus

14

0

2

0

Latvia

17

8

73

13

Lithuania

11

3

73

13

Luxembourg

15

3

59

13

Hungary

8

3

22

0

Malta

21

3

51

13

Netherlands

9

0

40

9

Austria

14

2

41

4

Poland

14

5

54

10

Portugal

19

5

40

0

Romania

0

0

7

3

Slovenia

13

0

44

13

Slovakia

28

4

16

1

Finland

12

0

63

13

Sweden

10

5

73

13

United Kingdom

2

0

21

0

Having had a torrid time, suffering the longest run of deflation in their sector in Europe, Irish restauranteurs have now begun to recoup with price rises. It is startling that in the face of a massive slump in disposable income we have not seen until recently deflation in Greece in this area and in culture etc

Recreation and culture

Restaurants and hotels

Since 1/08

Since 1/13

Since 1/08

Since 1/13

EU (de jure)

8

0

0

0

Euro Area (de jure)

11

0

0

0

Belgium

10

0

0

0

Bulgaria

34

13

0

0

Czech Republic

37

0

0

0

Denmark

15

1

0

0

Germany

3

0

0

0

Estonia

11

0

15

0

Ireland

47

9

33

0

Greece

23

13

9

9

Spain

41

0

0

0

France

63

6

0

0

Croatia

12

0

10

5

Italy

0

0

0

0

Cyprus

13

4

0

0

Latvia

32

4

21

0

Lithuania

26

0

15

0

Luxembourg

0

0

0

0

Hungary

0

0

0

0

Malta

44

0

5

4

Netherlands

34

0

0

0

Austria

0

0

0

0

Poland

26

0

0

0

Portugal

21

0

0

0

Romania

0

0

0

0

Slovenia

24

7

16

0

Slovakia

8

0

0

0

Finland

12

1

2

0

Sweden

48

13

0

0

United Kingdom

26

0

0

0

Finally in education and health Greece and Spain lead the pack. Despite the constant refrain that Irish healthcare costs are skyhigh the sector is resistant to change. Greece continues its slip into deflation

This is a version of my column published in the Irish Examiner 8 Feb 2014. It takes a long time to recover from a banking crisis. If we were unsure of that we need but look around and notice that we still are talking and fretting about ours.

Seven years ago Irish bank shares share prices were at or near all time highs. Lending for house purchases and deposits inflows to Irish banks were also at all time highs. So also were house prices. And then it all began to unravel. The children born at the bursting of the bubble, who will carry the cost most of their working life, are now in senior infants or first class in school. And still it isn’t fixed. Only this week do we see the first criminal trial arising from the banking shenanigans. This week also we saw a report by the EU which sharply criticized our lethargy in dealing with bringing criminal, especially white collar, trials to justice. The Cowen government moved neither swiftly nor decisively when the storm hit.

But things may be changing. At the annual meeting of the Allied Social Sciences, a sort of Woodstock for economists and likeminded folks, a paper was presented on banking crises. The link above is to the paper – there is a longer version but it is firewalled. Reinhart and Rogoff have previously come in for some (more or less justified) stick on account of a missed spreadsheet error in one of their papers. The paper in question was at the heart of the meme propagated that after 90% debt/GDP countries enter a death zone. However, to my mind their more important work by far is in economic history, where in a series of books and papers they have provided comparative data on banking crises and bubbles. Much of the problem with modern macroeconomics is a twin crisis of insufficient data and a lack of a historical perspective. There is no excuse for this in the area of banking crises as we have not only the work of RR but also a comprehensive database from the World Bank.

The RR work provides details of 100 banking crises. Its well worth reading. The main finding is that the effects of the crisis take a long time to peter out. In 50% of the cases real GDP per capita has not recovered to pre crisis levels even after 6 ½ years. On average it takes 7 years. Ireland has had a really severe banking crisis. RR create a measure of the crisis severity – the data are shown below. In terms of the post WW2 period it ranks in the top ten most severe crises as measured by declines in per capital GDP. What is however apparent is that we may, based on the real GDP per capita data available, be right on target to be an average recovery. Our GDP figures of course are somewhat distant from the reality of people on the ground, but the fact remains that GDP is what the rest of the world measures as being available for the state to distribute. That we have chosen to in effect shelter a large chunk (the fdi sector) is our own decision. Mind you, with the international moves to make tax arbitrage by MNCs less attractive, how long the GNP/GDP wedge will persist is debatable.

This does not mean we are out of the woods by any means. Entering the crisis with a healthy debt to GDP ratio of 25% in 2007 we are exiting it with one closer to 125%. Whether high debt causes slow growth, slow growth high debt or more likely both working together, this ratio needs to come down. And herein lies a problem. Europe, and Ireland, are teetering on the brink of deflation. We are used to inflation – rising prices. Deflation however is where prices fall. And while inflation can be bad at high levels deflation at even moderate levels is disastrous. With deflation there is little incentive to spend – prices will fall so why spend now. There is little incentive for firms to invest in new products –demand will be depressed until people consider that prices are likely to stabilize or rise. And for those with debts, that including states with high debt/gdp ratios and households with mortgages and personal debt, it is ruinous as the real level of debt increases over time.

At a wholesale level, the price that companies get, deflation is already a reality. Across a wide swathe of the Irish economy prices have been falling for 6 months or more. This is particularly evident in manufacturing and related areas. Indeed, surprising as it may seem to the consumer, it is also the case in most food areas, save dairy. At the consumer price level of the 12 main categories of goods and services 6 have shown deflation in the last two months. Indeed since 2010 deflation has been the norm in clothing, furniture, communication and recreation. At a European level overall inflation is now close to zero. What is needed is moderate, 3-6% inflation.

The ECB, again, is in the firing line, as it controls the money supply. However facing broken banks and close to the zero interest rate bound there is a limit to what monetary policy can do. Eurozone governments cannot pump inflation by fiscal means as they are constrained by the various macroeconomic treaties. We are heading for a decade or more of stagnation unless the ECB can both clean the banks and prime the pumps. What chance that ? Draghi has dismissed deflation as a risk – in his press conference he noted that while there was some deflation (but he didn’t call it that) in the program countries (Ireland, Greece, Spain and Portugal) this simply didn’t matter for the core. We have left the woods of austerity for the darker woods of deflation. And nobody who matters cares.

This is a version of my column in the Irish Examiner of 25 Jan 2014 .Europe’s banks are broken. Very broken. We have always suspected that, but recent evidence in indications suggest that nearly six after the crisis first began to manifest itself seriously they are still grossly impaired. The drive towards meaningful banking union has stalled again amidst squabbling about whether or not there should be and if so how much of a common pot for resolution. German banking giant Deutsche unveiled a billion euro loss just this week, underscoring how fragile both the banking system and the economy remain, even at the core. Without a working banking system the economy cannot prosper.

Recall what it is that banks do – despite the mystique and the bluster, its actually pretty simple. Some people have money and others need it. Banks act as a middleman to facilitate those that want it to get it from those that have it, in return for them taking a cut of the interest charged. This can be across space (savings flow from region to region) and/or time (mortgages and longer term loans) . Lending money out is risky. That is why banks charge an interest rate on loans that is greater than that which they pay on deposits – apart from needing to make a profit and cover costs, they need to put some money aside for the inevitable defaults and bad loans. These retained profits, plus some other ‘safe’ assets, are the banks reserves, or its capital

There is a persistent fallacy that banks lend out reserves. They don’t. People such as Frances Coppola have been banging on about this fallacy for some time now (see here and here) Its more complicated than that and revolves around the fact that banks can create credit (money) by issuing loans. However, banks do need, under prudential regulation, to hold a certain amount of capital, a proportion of the assets they have (loans made). If banks have more capital they are in a position to expand. The problem for European banks is that they are stymied by the fact that they have written down bad loans to an extent sufficient to impair their capital base but by no means enough to clean their balance sheet of the these bad loans. Caught in a double bind, they are unable to efficiently do their job as intermediaries and as credit creators.

As part of the ongoing efforts to get to the root of the problem the ECB have initiated an asset quality review. This is in effect yet another stress test. Previous not-terribly-stressful tests have been greeted with derision as they in effect claimed that all was well when it was manifestly not. Thus this stress test, to be credible, needs to fail some banks – any banks. It is reminiscent of Admiral Byng, who was shot not for failing at his task of taking Minorca, more or less impregnable and a rock on which others had foundered, but ‘pour encourage les autres’. European banks all stand in danger of being the financial Admiral Byng of 2014. One or more large banks needs to fail to show the virility of the tests.

Recent research has looked at what holes might be lurking in the capital. As has been the case throughout this crisis while high level public data cannot give a precise amount it has been remarkable how using such data the gross magnitude and nature of the money sink de jure has been accurately estimated. Looking at the 109 largest banks with €22 tr in assets a hole of between 5b and 66b is found even assuming no further deterioration of any assets – an unstressed situation. The biggest holes are in the core – French and German banks and the smallest in the periphery. Ireland, if things don’t get any worse, does not need any more capital in its banks.

But what if things do go south? They stress the banks rerunning a severe financial crisis, and further suggest that any residual bad loans are written off. Writing off bad loans of capital weak banks is the only way to kill zombie banks who crowd out and hinder the banking system. In this stress situation the banks are woeful. Assuming reasonable levels of reserves to be held, European banks may need between 500b and 750b. Again the worst holes are in the core banks especially French German and Belgian banks. Top of the list are the giant french banks – Credit Agricole, BNP and SocGen, and Deutsche Bank. Bank of Ireland and AIB are not immune, possibly requiring 6-13b euro more. But sure were good for that, havent we turned the corner and exited the bailout to a land of green shoots…

So what to do? Senior bondholders are sacrosanct and while depositors of unimportant nations such as Cyrus (whose banks are still bunched beyond reasonable hope of redemption) might be bailed-in that wont happen to real depositors, those of the core. So banks will limp along. But there is a potential solution – promissory notes. The notes were created to shore up the capital base of Anglo Irish Bank, and allowed it to access liquidity from the Central Bank of Ireland. Which it did. Ok, Anglo was a hopeless case but the principle is good. The problem with the notes was not per se their existence – it was that they were required to be extinguished over a fairly swift timetable, placing unbearable strain on an already strained exchequer and that it was done to put a figleaf on the notion that Anglo was a going concern.

Were these or national equivalents to be created by the national authorities of the core, we could well imagine much longer periods for extinguishing being placed in play. If the Anglo ProNotes had been repaid over 300 years instead of 30 they would not have been an issue, except morally. While the numbers seem large, in the context of the (shrinking ) ECB balance sheet of 2.2b even the largest amount required is not unbearable. Part of the ECB objection to the notes was that the liquidity created was done so “outside its control”. A system of central banks cannot have individuals pursuing their own monetary policy in an uncoordinated and national focused way – that is what brought down the Rouble zone. But as a once off final fix for the banks? Its worth a shot. In all probability the 750b would not be required in full. While the 40% fall over 6 months in equity values is high, this does not happen very often – but it does happen about 1 time in 25. Doing this would ‘cure’ the banks, in so far as it would allow, in fact would have to be accompanied by, a full write-down of impaired loans and thus position them for regrowth. It would allow a clean start to be made. Clean the mess up once and for all, and restart.

Alas, the inflation hawks and their fears dominate the ECB, fears never more imaginary than now with deflation staring the Eurozone in the face, will not allow this. The consequence is that we flirt with a further crisis not merely knocking out the periphery but the core. As we have throughout the crisis we face a choice of unpalatable alternatives. European banks will follow the irish lead – either via partial or full zombification with the odd twitch of life now and again while hoping that the economy does nothing remotely scary all the time barely functioning and taking a decade or more to get back to any health, or by the solution which worked, in that it allowed a bank to be cleansed and to br resolved.

after the congratulations of the Forbes report on us being the best little country in the world in which to do business, here are two charts that might make us take pause…

Both are from a new ESRI study. They are on relative poverty risk in the EU. It looks at what is called the “at Risk of Poverty Rate” AROP. This is defined as

The at-risk-of-poverty rate before social transfers is the share of persons with an equivalised disposable income, before social transfers, below the risk-of-poverty threshold, which is set at 60% of the national median equivalised disposable income (after social transfers).

Think of it as just at risk of poverty.

First, across the EU.

Yes.. we are number one. Without state transfers fully 1/2 of the population would be at risk of poverty. But it gets more stark…look over time. We have seen the largest increase in AROP since 2005.
This, this is success?

This is an edited and extended version of a column in The Irish Examiner 26 October 2013

There is a great book on marketing titled “the long tail” , which stresses that instead of trying to hit millions of customers at once its perhaps better to do millions of niches. Replete with examples it was and remains a deserved hit. The long tail refers to the distribution of something – a large bulk at one end quickly trailing off to smaller numbers but which go on for a long time. Another word for this is skewness. In very many skewed distributions it is common for the total amount in the long tail to be equal to or greater than the amount in the bulk. Another way of thinking of this is a power law. Many many things have been found to follow power laws – terrorism, population of cities, bibliometrics, income distribution… theres no reason to think Irish bank losses are different.

The long tail approach is worth considering as we move into the sixth year of this crisis. Having dealt with the massive mess of the commercial property and developers loans via hiving them off to NAMA (which has yet to “get credit flowing” as its cheerleaders in the then government and some still prominent stockbrokers trumpeted) , the long tail of the mortgage and SME loans continue to erode the banks. We are moving down the tail with the average loss getting smaller but there are an awful lot of them. Today I spoke to a SME owner who runs a small distribution business. He had settled with a bank for a loan taken out in 2006 which resulted in the bank taking a loss of just under €1m. The business is still going, much reduced but “ticking over nicely”. This is as good as it gets – a viable business remains. Many many SME loans are for larger amounts and the banks will take a larger hit as there is nothing left. I think of someone I know who purchased a house in 2006 for €450k, interest only of course, in a not very fashionable holiday area, where similar homes are selling at €150k on a good day. These are the long tail and they are wagging the dogs of our banks as the banks chase them round in a circle.

At present Irish banks are well capitalized. Some might say that in a classic overreaction to the lack of adequate capital buffers in the past they are over capitalized. Bank capital is a two edged sword. On the one hand the more capital they have the greater a buffer exists to absorb losses. On the other, as capital is measured as a percentage of assets the more capital is required then all things considered the smaller will be the assets. A bank that has a 10% capital ratio will be able to make more loans (assets) than one that is required to hold a 15% ratio. The ECB has recently announced that it will conduct another round of stress tests. These are required, in essence, so that the final set of capital injections will be made prior to the ECB taking over full control of regulation. The political reality is that this step, a necessary requirement for a proper banking union, will require that individual states make or supervise any capital injections. In a banking union this will be the responsibility of the union, and thus the German taxpayer might be on the hook. But not this last time.

We have known for some time that the Irish banks will require additional capital. The state of the mortgage book is bad but the state of the SME loan book is also dire. Earlier this year we found out that 50% of the SME loan book was in distress. There is a total of €70b in SME lending, of which an astounding €30b is still outstanding to real estate. A multibillion loss is an absolute certainty. On the mortgages we have similar. The question that should raise its head is : who bears these losses. Traditionally the order of losses was deemed to be shareholders -> junior bondholders -> deposits and senior bonds. The taxpayer might then step in and recapitalize if the bank was deemed to be needed. So in the Irish case 2008 saw some but not all junior bondholders and almost all equity destroyed, but the system balked at that and so in stepped Paddy with his chequebook. And we know how that ended. We saw in Cyrpus, and indeed have seen in the liquidation of IBRC that depositors can and in future will be “bailed in”. This is fine and dandy if all other sources of capital have been burned through. The problem is that recent statements by Mario Draghi suggest that bondholders might be spared in future, for fear that once burned they might not return. In other words the sovereign would be required to make a decision as to whether they would absorb losses or instead force bailins on depositors. There is zero willingness for the Irish state to add more taxpayer money into the banks. Thus the question becomes: do the banks hae sufficient buffers in place to absorb losses before the question of depositors comes into play?

On a macro level they are good. AIB has shareholders funds of c 10b, BOI of 8b and PTSB 2.4b. In the case of PTSB and AIB much of these shareholder funds are in fact state funds, so any erosion of these is an erosion of taxpayer funds. The problem is that as we noted they are required to hold funds at a certain level. This level is higher than the European requirements. Thus as losses get booked the banks will have to either raise additional funds. This, in sufficient amounts, is I submit unlikely. While they have had some success in raising limited amounts these have either been expensive or have required significant security. In addition, the banks face rollovers of existing issued debt. Bank of Ireland will need to roll over or pay off bonds of 9.5b in 2014-2015, AIB 7.5b and PTSB 5b n the same period. This will tax them significantly. If they face a requirement to otherwise increase capital from losses that will make the job that much more difficult. A large part of the outstanding bonds are senior notes, some 7b. A large part of the remaining is covered or asset backed. Only some 5b or so across the banks, mainly in Bank of Ireland, are unsecured or subordinated. Bank of Ireland has the largest “burnable” buffer but is the one least likely to require it. AIB has very little unsecured debt and less than 4b senior debt. We have seen that even the mention of senior debt being burned, where legally possible, has caused significant negative market reaction. Thus where there is no taxpayer backstop and either no bondholders or no willingness to burn them, inevitably deposits must come into play. In that context depositors should seek a higher rate than they are at present getting.

The chart shows the deposit rate on new deposits for an agreed maturity, Ireland v Germany. Deposits that were ten years ago seen as close to riskless as it is possible to be are no longer so perceived. The difference between Irish and German deposits is not, I suggest, sufficient to reward for the relative risk differential. Although small, the risk of depositor bailin in Ireland is many many times larger than that in Germany. These risks are the worst sort- small probability large outcome risk. It is time that the banks begun to remunerate depositors appropriately for the risk, small that it is, that they are being asked to bear. We need to move away from a banking system that is dependent in large part on loan capital towards one that is dependent on deposits. In fact, in the last week we have seen the situation worsen. The increase in DIRT means that deposits are now paying less than the already paltry levels. Combined with the loss of ACC , closing after 86 years, this further erodes competition, even if ACC was a small player. Expect pressure on interest rates to be downward, relatively speaking, on deposits. Which are now risk capital and in the firing line.